A home equity loan lets you convert your equity into cash. You can borrow between 80 and 90 percent of your home’s value minus what you owe on the mortgage. So if your home is worth $395,000 and you owe $275,000 on your mortgage, you could qualify for a home equity loan between $41,000 ($395,000 * .80 – $275,000) and $80,500 ($395,000 * .90 – $275,000).
Funds are dispersed in a lump sum and payable in equal monthly installments over a set period. Plus, the interest rate is fixed, so you won’t have to worry about fluctuating monthly payments.
But is a home equity loan a good idea? Read on to learn more about the benefits and drawbacks of home equity loans and a debt-free alternative to tap into your home’s equity.
What are Home Equity Loans and How Do They Work?
Home equity loans are secured loans that let you access your property’s equity. Every homeowner builds equity over time through monthly mortgage payments. You also get additional equity when you make a down payment and when the property appreciates.
You can use home equity for any purchase. These loans can help with emergency expenses, your next vacation, or the down payment on another property. It is common for real estate investors to use leverage and borrow against existing properties to finance new properties.
While there are multiple ways to borrow against your property’s value, a home equity loan offers the most stability. This loan has fixed monthly payments over a loan duration that you get to decide. Most lenders let you take out a loan term ranging from 5-30 years. These monthly payments are more predictable than a home equity line of credit, which has a variable interest rate.
Factors to Consider Before Applying for a Home Equity Loan
Homeowners have a lot to consider before applying for home equity loans. These are some of the details to keep in mind before starting the process.
Assessing Home Equity
Review your current home equity to see how much you can access. Most lenders use the loan-to-value ratio to determine how much equity you can access. If a lender sets an 80% LTV ratio, then your current mortgage and home equity loan cannot exceed 80% of your home’s value.
People with more home equity can borrow more capital through a home equity loan. Homeowners who don’t have much equity may have to work with a lender that accepts 90% LTV ratios.
Understanding the Terms of the Loan
Home equity loans require monthly payments the moment you take them out. You can pick a loan term ranging from 5 to 30 years, and the length of the loan impacts your monthly payments.
A longer loan term will keep you in debt longer, and you will pay more interest in the long run. However, lengthier loans also result in lower monthly payments. If you have a tight budget, a loan with more years can be a good move.
Budget for Repayments
Home equity loans let you access the funds you have built up in your home. However, you have to repay that loan or risk losing your property. That’s because home equity loans use your house as collateral, just like a traditional mortgage.
Before finalizing the terms for your loan, consider how much you can comfortably pay each month. You don’t want to feel nervous about making monthly loan payments and should extend the loan’s duration to mitigate stress. It’s also important to consider that you will have to keep up with monthly payments for the home equity loan and your current mortgage.
Home Equity Loans Pros and Cons
Here are some key benefits and drawbacks of home equity loans:
Home Equity Loan Pros
- You won’t have to refinance your current mortgage. If you secured a low interest rate when you purchased your home, it would remain intact.
- The fixed interest rate makes it easier to budget for monthly payments, as the amount won’t change over time.
- The extended repayment period makes the monthly payments affordable. Some lenders offer up to 20 years of repayment terms in home equity loan proceeds.
- You can possibly deduct interest paid on the loan if the proceeds are used for home improvements. In most instances, this amount is limited to $100,000. It’s best to consult with a licensed tax professional to learn more.
- The interest rate is generally lower than what you’ll find with other credit cards and loan products.
Home Equity Loan Cons
- You need good to excellent credit to qualify. Homeowners with credit scores of 620 or lower could be denied.
- You likely won’t be eligible if you have little to no equity in your home.
- You could lose your home if you fall behind on payments since it’s used as collateral.
- Interest is assessed on the entire loan amount from day one, even if you don’t use all the loan proceeds right away.
- If you sell your home, you’ll have to pay the entire outstanding balance. Most homeowners use proceeds earned from the sale to cover the balance. But if there’s a shortfall, you will pay the difference out of pocket for the transaction to close.
Is a Home Equity Loan a Good Idea?
It depends on your financial health and how you plan to use the funds. But be mindful that with a home equity loan or a home equity line of credit (HELOC), you’ll essentially be putting your home on the line. Plus, you’ll be adding to your current debt load. So, it’s pertinent to ensure you’re making an informed decision.
A home equity loan can be necessary to cover emergency expenses, especially the big ones like medical bills. Home equity loans typically have lower interest rates than most types of financing. It is more expensive to take out a personal loan or rack up credit card debt. Monthly payments for 30-year terms will make repayment more manageable than most types of loans.
Home equity loans are also great choices when interest rates are low. You can lock in a fixed rate if you use a home equity loan. However, a HELOC has a variable rate, which means that the rate will increase if the Federal Reserve decides to raise interest rates in the future.
When A Home Equity Loan May Be a Good Idea
A home equity loan may be a good idea if you’re looking to eliminate high-interest debts or meet other financial goals. You will likely save money by using the proceeds of a home equity loan to wipe out your credit card debt. Many homeowners also use these loan products to make costly improvements to their homes.
However, you should have a stable income to make payments on the loan comfortably. It’s equally important that you follow a spending plan each month to avoid overspending. You want a safety net that can be used as a last resort if you experience financial hardship to ensure you can stay current on your payments.
Some real estate investors must use home equity loans to acquire cash-flow-positive real estate properties. These investors want to scale quickly and discover profitable opportunities in the market. If they are short on cash, they can borrow equity against their properties to fund the down payment. Leverage is risky, but an investor with a solid income and many tenants can more easily facilitate these types of transactions.
When You Should Consider Other Options
Are you eager to pull the equity out of your home but don’t quite have a plan for how the funds will be used? You may want to hold off or consider other options. Furthermore, a home equity loan likely isn’t a smart financial move if your income is shaky and you have trouble staying afloat financially. You can end up losing your house if you fall behind on your current mortgage or your home equity loan. If you pay one of them but not the other, the bank can take your house if you fall too far behind.
An unsecured personal loan could be a better deal if you have a decent credit score and need fast cash. Or you could explore credit cards that offer promotional annual percentage rate (APR) periods if you need access to funds and can repay what you borrow before the promotional window ends. It’s possible to get 0% APR for a credit card for a 12-18 month introductory period.
You should also consider when you will use the funds. One of the big perks with HELOCs is that you only pay interest when you borrow against the line of credit. However, you immediately pay interest on a home equity loan. If you don’t plan on using the loan’s proceeds for several months, you should consider a HELOC instead to save money.
Ultimately, a home equity loan can be risky without a solid plan for how the loan proceeds will be used. So, you’re better off thinking this through before applying for a secured loan that uses your home as collateral.
